Capital Group Presentation

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Financial Analysis of IT Investments Prepared by
John Lafare Vice President Director,
Information Technology Group The Capital Group
Companies
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About the Capital Group

• Who we are
• One of the worlds largest and most respected
• investment management organizations
• American Funds and Capital Group International
• Investment manager of mutual funds, separately
  managed accounts and pooled investment funds
• 9,000 associates in 19 offices worldwide
• Privately held organization founded more than 75
  years ago
• Experienced, long-tenured investment
  professionals
• Known for exceptional customer service

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Most Projects Do Not Add Value to the Firm

• 20 of all IT spending is wasted representing an
  annual destruction of value of several hundred
  billions
• A 24 budget over-run, coupled with a 16
  shortfall in delivered functionality and a
  two-year delay in implementation, can turn an
  expected return on investment of 14 into a
  negative return of 38.
• Changing business needs and unmet expectations
  are leading causes of project failure
• Nicholas Carr of Harvard IT Doesnt Matter
• Less than 18 of the typical IT budget is
  actually spent on initiatives that bring value to
  the enterprise
• Only innovative investments seem to increase
  firms value

Keep in mind the economic axiom that excess
profits (the source of value) are zero in a
competitive market, and that for a project to
truly have a positive NPV, it must have some
competitive edge -- be first, be best, be the
only.
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The Origins of IT Financial Analysis

• Early 1950s Harry Markowitz formulates the
  groundbreaking theories on modern portfolio
  management
• Key concept a diversified portfolio of financial
  assets can be optimized to deliver the maximum
  return for a given level of risk
• 1981 Warren McFarlan argued that the
  fundamentals of portfolio management should be
  applied to corporate technology assets

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Financial vs. IT Portfolio Management
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Criticism of Quantitative Analysis

• Issues with the financial analysis of IT
  investments
• Most IT departments endorse ROI measures but do
  not apply them broadly or rigorously
• Failure to quantify project investment value
  leads to skepticism about returns from large and
  growing IT expenditures
• Some encourage migration away from cost-benefit
  analyses, especially ROI models
• The more strategic IT becomes, the more soft
  metrics surpass financial measures in utility
• ROI fails to account for project risk, size,
  complexity or longevity and may be best suited
  for low-risk projects
• ROI is a poor measure when investment may result
  in a wide array of outcomes or lead to successive
  investment opportunities
• ROI is a weak valuation metric for long-lived
  investments
• ROI is inadequate for comparing investment
  opportunities when the amount invested is a
  deciding factor in resource allocation

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Abandoning Financial Analysis Not The Answer

• The correct solution is to upgrade the
  cost/benefit toolkit
• Because IT projects vary as to complexity and
  risk, different metrics suit different
  investments
• Attribute earnings to intangible benefits to
  reveal true business value

High
High
Real Options
Complexity of Metric
Monte Carlo Simulation
Complexity of Cash Flows
Sensitivity Analysis
NPV/IRR
ROI / Payback Period
Low
Low
Uncertainty of Cash Flows
High
Low
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Beware The Limitations of Methodologies

• Models assume we can identify all relevant
  decision-making factors
• Methodologies limit what kinds of factors they
  can consider
• Inclusive decisions typically require more than
  as input
• Not including the right combination of factors
  can limit what is considered in the final
  investment decision
• The factors may have been measured incorrectly or
  contain bias
• The time frame of IT investments and the delivery
  of benefits frequently do not keep to a predicted
  time table
• Financial methodologies tend to exclude most
  considerations of intangible benefits in
  preference to tangibles ones.
• Investments in IT are subject to higher risks
  than other capital investments

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Payback Period Calculation

• How long will it take for the investment to pay
  for itself?
• Widely used measure in tough economic times
• It's easy to compute, easy to understand and
  provides some indication of risk by separating
  long-term projects from short-term projects.
• Emphasis on short term has special appeal as the
  history of IT projects taking longer than three
  years is very mixed

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How to Use Payback

• Limitations
• Payback doesn't measure profitability, ignores
  financial performance after the break-even period
  (1)
• The simplicity of computing payback may encourage
  sloppiness
• Recommendations
• Consider payback period in concert with other,
  more sophisticated measures
• Good way to quickly size up a portfolio of
  projects and winnow it down to a few that merit
  more careful scrutiny

(1) The Server Consolidation Project has a more
attractive payback but the Back-Office Automation
project is a better long-term investment
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Net Present Value Calculation

• Net evaluation of multi-year investments
  expressed in today's dollars
• Incorporates the time value of money
• Is simply the sum of all discounted outflows and
  inflows
• Allows consideration of cost of capital, interest
  rates, and investment opportunity costs
• Especially appropriate for long-term projects

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How to Use Net Present Value

• Limitations
• Does not compare the absolute levels of
  investment
• Highly sensitive to the choice of a discount rate
  (see example)
• Works only where benefits can be associated with
  cash flows
• Recommendations
• Use simple measures such as payback period to
  evaluate smaller projects, but look at NPV for
  larger projects
• Good "no-go indicator," as you'd normally reject
  projects with negative NPV
• Projects NPV gt 0 can further be measured by other
  yardsticks

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Internal Rate of Return (IRR) Calculation

• It is about recovering the cost of investing
• Interest rate that provides an NPV of 0 for the
  cash flow stream
• Internal means it is strictly a function of
  project cash flows
• Used as a hurdle rate projects must exceed to
  receive funding
• When projects compete, select the one with
  highest IRR
• Often preferred and used by financial specialists

IRR(NetCashFlows, 0.10)
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How To Use The Internal Rate of Return

• Limitations
• Value and meaning more obscure to many people
• Does not account for absolute size of the
  investment
• Errors magnified when comparing projects of
  different durations.
• Most meaningful when large inflows follow large
  initial outflows
• Return rates may not be realistic (1)
• Recommendations
• Can be used as a go/no-go investment threshold.
• If IRR is less than hurdle rate, you need a lot
  of soft justifications

(1) In reality, investors would not count the
cost of funds at the IRR rate and the invested
funds would not earn returns at the IRR rate
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Return on Investment Calculation

• How do investment returns compare to investment
  costs?
• Used to evaluate the efficiency of an investment
  or to compare the efficiency of different
  investments
• Very popular metric due to its versatility and
  simplicity
• If the investment has a negative ROI or other
  opportunities have a higher ROI, then the
  investment should be not be undertaken

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Return on Investment Calculation

• Limitations
• Some ROI models can become overly complex
• They are not well suited to the capture of soft
  benefits
• Assumes that returns are match with costs (not
  easy to prove)
• Recommendations
• There is no such thing as a right or optimal
  ROI it all depends on what you include (or
  exclude) in the model (see example)
• The flexibility of ROI calculations has a
  downside as they can easily be manipulated to
  suit the user's purposes
• Make sure you understand what inputs are being
  used

• Consider the following data for a proposed CRM
  project
• Estimated Project Cost 1,000
• PV of Expected Benefits 1,100
• Projected increase in revenue per customer 100
• Per customer cost of future marketing campaigns
  80
• Hurdle rate 15
• Financial ROI 1,100 - 1000 100 / 1000
  invested 10
• Marketing ROI 100 - 80 20 / 80 25

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NPV vs. IRR vs. ROI

• Below is a comparison of 5 financial metrics for
  3 different proposals
• Each metric identifies a given proposal as best
  depending on the year
• ROI and IRR agree in some years and disagree in
  others
• Bottom line strong need for understanding of
  each financial metric

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Sensitivity and Risk Analysis

• Sensitivity analysis ask what happens to
  predicted results if assumptions change?
• Risk analysis is about assessing the likelihood
  of expected outcomes
• They help identify revenues and costs that have
  the greatest impact on NPV, IRR and other
  financial metrics of a project
• They provide a way to understand and adjust for
  risk
• Easier to implement with the advent of
  sophisticated computer models (Monte Carlo
  simulations, etc )

All Assumptions
Important Assumptions
Unimportant Assumptions
Assumptions That Cannot be Managed or Controlled
Assumptions That Can Be Managed or Controlled
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How To Use Sensitivity and Risk Analysis

• Limitations
• Thorough understanding of variables in the model
  required for accurate estimation
• Single-factor sensitivity analysis when in
  reality assumptions are often correlated
• For complex scenarios, developing models is
  cumbersome
• Recommendations
• Can help provide the means of understanding the
  moving parts of the projects investment
• Allows the attribution of risk levels and the
  evaluation of the probability of the alternative
  outcomes for a project

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Real Options

• Application of financial options theory to the
  identification of options created by technology
  positioning investments
• A Real Option is the right but not the obligation
  to undertake a financial investment
• Accounts for the value created by the ability to
  defer, expand, contract, abandon or otherwise
  alter a project
• Real options are also embedded in the opportunity
  to invest in innovative projects with
  consideration of the strategic value associated
  with the possibility of follow-up investments

Discounted Cash Flow vs. Real Options Approach
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How To Use Real Options

• Limitations
• Real options methods are often complex to model
• Assumptions of financial models (Black-Scholes,
  binomial option pricing models) place constraints
  on the range of IT investment situations that one
  can evaluate
• Recommendations
• Use for appraisal of project value under
  conditions of uncertainty
• Whenever an IT project has flexibility about
  which applications and functions to implement,
  and when or how to implement them, real options
  are present
• The growth option is most useful when considering
  infrastructure projects which often carry a
  negative NPV but whose value is the enablement of
  future investments
• Due to potential complexity, apply a simplified
  version of options pricing (note that it may
  lead to decreased estimation accuracy)

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Conclusions

• Projects may have their roots in routine
  operational tasks
• Many IT projects also assist in providing new
  revenue sources
• The common goal for all properly identified
  projects is to provide value to the organization
• Numbers alone do not suffice but a financial
  model lies at the heart of a good business case
• Financial metrics help verify that the IT
  investment is a good business decision
• Concepts such as NPV, IRR, or ROI come straight
  from the discipline of finance
• Each method measures something different and must
  be carefully selected to meet the needs of the
  decision makers
• When selecting a methodology, you must understand
  its design, bias, and proper areas of application

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Financial Analysis of IT Investments
Questions?